Riley points out that, although many markets ended the past week only moderately down or, in some cases, up from their start, these modest shifts belie significant price swings.
“The biggest winner of the week was volatility,” he said, “The VIX index peaked above 50, its highest level since 2008-09 before easing below 30 by the end of the week, still its highest level since the height of the Eurozone debt crisis.
Agreeing that liquidity tends to be lower in August as a result of the summer lull, he told Portfolio Adviser that there are a number of structural factors at work as well which has meant that the market is seeing more of these high volatility episodes following periods of low volatility.
“If you like, the volatility of volatility has risen,” he said.
Indeed, he said, the first lesson to take away from last week’s overreaction to growth in China is that the lower liquidity and shallower market depth that has been at the top of bond investors’ worry lists actually extends well beyond credit markets.
The second lesson is that the current market fragility is exacerbated by the effects of dominating central bank policy that is “herding investors to face the same way in terms of positioning, contributing to market discontinuities – ‘price gapping’ – and volatility,” he said.
Complicating this picture for investors was the fact that while volatility rose, so too did correlations, at the same time as dispersion fell.
According to Tim Edwards, senior director, index investment strategy, S&P Dow Jones Indices, this situation (were dispersion was low correlations high and indices were falling) posed significant challenges to investors because: “little value could be added by picking the right stocks, and diversification offered little if any protection.”
He added: “Extraordinarily high correlations tied performances together. August’s 0.81 average stock-to-stock pairwise correlation in Europe is the highest on record. For the S&P 500, correlation rose to its highest in four years. Leading into a closely watched U.S. Federal Reserve meeting in September, continued high correlations will amplify the market’s response, raising the stakes for investors.
Riley too expects volatility to continue and agreed that part of the issue is the herding behaviour seen in many investors, especially, he says, as national economic and policy conditions continue to diverge.
“In an investment environment characterised by low market returns and bouts of extreme volatility, investors will we believe place an ever greater onus on active risk management and capital preservation,” Riley added.
